Crowdfunding poses pitfalls for business owners

Published 4:00 am, Sunday, April 1, 2012

Photo: Jonathan Alcorn, Bloomberg News

Image 1of/1

Caption

Close

Image 1 of 1

An animated Ozzy Ozbourne character from the Electronic Arts Inc. game Brutal Legend appears on screen as Tim Schafer, president of Double Fine Production, speaks during an Electronic Arts news conference prior to the start of the Electronic Entertainment Expo (E3), in Los Angeles, California, U.S., on Monday, June 1, 2009. The video-game industry's biggest sellers, including Sony Corp., Microsoft Corp. and Nintendo Co., are looking to this week's expanded E3 Expo to return some excitement to a slumping industry. Photographer: Jonathan Alcorn/Bloomberg News
An animated Ozzy Ozbourne character from the Electronic Arts Inc. game Brutal Legend appears on screen as Tim Schafer, president of Double Fine Production, speaks during an Electronic Arts news conference prior to the start of the Electronic Entertainment Expo (E3), in Los Angeles, California, U.S., on Monday, June 1, 2009. The video-game industry's biggest sellers, including Sony Corp., Microsoft Corp. and Nintendo Co., are looking to this week's expanded E3 Expo to return some excitement to a slumping industry. Photographer: Jonathan Alcorn/Bloomberg News less

An animated Ozzy Ozbourne character from the Electronic Arts Inc. game Brutal Legend appears on screen as Tim Schafer, president of Double Fine Production, speaks during an Electronic Arts news conference prior ... more

Photo: Jonathan Alcorn, Bloomberg News

Crowdfunding poses pitfalls for business owners

1 / 1

Back to Gallery

Many writers, including myself, have warned of the risks investors will face if they buy unregistered stock in privately held startups via the Internet or social media. This will become legal under a crowdfunding measure that Congress approved last week and President Obama is expected to sign.

But business owners also face risks if they choose to raise money this way, including the chance of getting personally sued under securities laws and getting distracted by lots of small investors.

They also might find it harder to raise venture capital if they already have a crowd of shareholders. And if their original investors sell or give away their stock to lots of others, the business could be forced to go public if it ends up with more than 2,000 shareholders of record.

These risks could be mitigated by Securities and Exchange Commission rule making or the help of a good attorney or equity-crowdfunding portal. Even so, the bill "is not a panacea for the funding problem" facing small businesses, says Jason Best, a co-founder of Startupexemption.com, which helped push it through Congress.

Latest business videos

The crowdfunding measure is part of a larger bill, HR3603, that will make it easier for some companies to go public and others to remain private. Unlike other parts of the bill, which had support from venture capitalists and other big-money interests, the crowdfunding provision was a grassroots effort.

"People picked up on the idea because it was techy - small business and everyone loves startups," says a Senate staffer involved in drafting the bill. "President Obama latched onto the idea and thought it was really exciting." After Obama signs the bill, the SEC has 270 days to write rules implementing it.

Heavy obligations

Under existing law, firms that want to sell securities to the public must register with the SEC and meet the heavy obligations of public companies, unless they meet certain exemptions. One exemption lets companies sell unregistered securities only to wealthy people known as accredited investors.

The new bill lets companies raise up to $1 million every 12 months from anyone, without going public. The transaction must go through a regulated intermediary - either a broker or new entity dubbed a funding portal - that also must register with the SEC and a self-regulatory organization.

Many nonprofits and politicians already use crowdfunding - raising money over the Internet and social media - to get donations. Many companies have also used it to finance new projects, as long as they are not selling securities. Instead they offer T-shirts, products or other freebies in exchange for contributions (which are not tax deductible.)

Double Fine's dough

Double Fine Productions, a San Francisco video game design studio, broke crowdfunding records this month when it raised more than $3.3 million from 87,000-plus people over Kickstarter, a funding platform for creative products. Double Fine's goal was to raise $400,000 for a new game and documentary. Backers were offered a copy of the game, movie and other incentives. The top prize, for contributions of $10,000 or more, was lunch with the game's creator.

People sent in money "because they wanted to be part of something creative, they wanted a product they hadn't seen in a few years," says Tim Schafer, Double Fine's chief executive.

Schafer says he would consider using crowdfunding to sell stock at some point. "I like the idea of fans being able to participate in the profits of the game."

But for now, he sees no reason to give away equity for a measly $1 million. "We raised three times that giving away lunches and T-shirts," he says. "People taking chunks of our equity is something we are trying to get away from."

Schafer says he could see it working for other companies. "Not everyone is doing a creative project, which brings about a certain kind of backer," he says.

The VC problem

Jared Kopel, a San Jose securities attorney, is not sure what kind of companies will benefit. In the Bay Area, it's not that hard to raise $1 million or $2 million if you have a good idea. "There are so many angel (investors) and wannabe angels," he says.

The real problem is when you need that next $3 million to $5 million to ramp up production. "That money is very difficult to get. I don't think crowdfunding solves that problem," Kopel says.

Having a crowd of investors could even make it harder to bring in venture capitalists. "We would have a lot of concerns about stepping into a company that has crowdfunding," says Shomit Ghose, a partner with Onset Ventures in Menlo Park.

Normally, the first investors in a startup agree to invest in later rounds of financing. If they don't, their ownership stake gets diluted as new investors come in. Large investors understand this. Small ones might not.

It could also be a problem if the company requires shareholder approval for a second round of financing and the crowd won't give it, "or if the crowdfunding source says we have the right to buy 50 percent of any subsequent funding round," he says.

A company can "engineer around" these entanglements, Ghose adds. "No doubt there is some segment this will make sense for. For the kinds of companies we invest in, probably not."

Others insist it will be a good way for small firms to sell securities. "There are a lot of businesses that are not right for venture capital or angels," Best says. "Maybe it's a dry cleaner in your neighborhood that wants a second location."

Slava Rubin, founder of Indiegogo, a San Francisco crowdfunding platform, agrees. "People have been asking us about this since we opened in January 2008," he says.

Rubin says Indiegogo is interested in becoming a portal for securities crowdfunding, but "we need to understand the amount of effort (and money) needed to comply with the SEC rules."

They will also have to do background checks on the company's officers, directors and large shareholders.

Companies that want to raise money will have to make certain disclosures about their business, capital structure and finances - ranging from a tax return to an audited financial statement. They will also have to issue an annual report.

How they reach investors is not entirely clear. The bill says companies cannot advertise the terms of the offering - they can only direct potential investors to the broker or portal. However, they can pay a third party to promote the offering through communication channels provided by the funding portal or broker, as long as the payments are disclosed. The portal is not allowed to recommend specific offerings.

Another big question: Where will investors trade crowdfunded shares after their one-year holding period expires?

Greg Brogger is president of SharesPost in San Bruno, a marketplace for trading in privately held companies such as Facebook. He says he is interested in creating a market for crowdfund investments, but "there is a fair amount of rule making the SEC has to do" before that could happen.

David Marlett, an attorney who runs Crowdfundsecurities.com, says there will be a "land rush" of companies offering portal and other services to companies seeking to raise money. His website has a list of them. "Right now it's the Wild West, but it's going to settle down pretty quickly," he says.

Latest from the SFGATE homepage:

Click below for the top news from around the Bay Area and beyond. Sign up for our newsletters to be the first to learn about breaking news and more. Go to 'Sign In' and 'Manage Profile' at the top of the page.